Weekly Stock Options Trading Tips: January 5, 2009

Stock Options Trading Idea of the Week

How to Cope With Falling Implied Volatilities (IV)

If you are less than 77 years old, you have just experienced the worst year for the market in your entire lifetime. Congratulations on surviving. You probably have a few scars like everyone else, but hopefully, the New Year will bring better results.

We want to start the New Year off by discussing the best way to deal with falling volatilities of option prices. 

There were two ways our Mighty Mesa Strategy can lose money – by a greater than moderate underlying stock price move, and by falling Implied Volatilities (IV).

There are two ways we can cope. First, we can maintain a strong positive net delta position. IVs tend to fall the most when the market is rising. By being longer than normal, we will benefit from the positive net delta as the stock rises, and this will offset some or all of the loss we incur from the falling IV.

The second way we can cope should be far more effective. When IV is falling, you want to be short as many options as you can. You can get short the most premium for your money by selling higher-value options and buying lower-value options in the same expiration month. For example, for calls, you would buy a higher-strike same-month call and sell a lower-strike same month call. You would collect a credit for each spread. You would have to come with enough money to cover the difference in strike prices ($100 per contract per dollar difference in the strikes) less the credit you collected.

For example, if you bought a SPY Feb-09 102 call for $1.10 and sold a SPY Feb-09 98 call for $2.25, you would collect $115 per spread. This would require a maintenance requirement of $285 ($400 - $115). If SPY closed at any price below $98, you would make a gain of $115, but for every dollar above $99.15, you would lose $100. At any closing price above $102 you would lose $285.

You can place similar spreads with puts, buying a lower-cost, lower-strike put and selling a higher-cost higher-strike put. If you place both a put spread like this and a call spread like we just discussed, you end up with a short iron condor. The neat thing about combining these spreads is that you can’t lose on both of them – one of them will be pure profit. In the above example, if you could sell the put vertical spread for $115, your total potential gain from the two spreads would be $230 and your total potential loss would be $170. Since your broker understands that both short vertical spreads can’t lose money, only one maintenance requirement is necessary rather than two.

Every significant options book will tell you that one of the best ways to profit from falling IVs is to place a short iron condor. We have used these in the past, and our experience was that most of the time, in about 6 out of 7 months, we made nice gains. However, in the seventh month, we might lose the entire investment for the past six months because the underlying moved outside the range of the long positions. For this reason, we stopped employing short iron condors.

Next week we will discuss how you can easily convert existing calendar spreads into a short iron condor.

Happy trading.

Andy's Market Report

It was another holiday shortened week for the market and this time the bulls made a grand appearance. All four of the major indexes gained over 6% for the week, but unfortunately the strong performance can’t hide the disappointment that 2008 brought for the market. The S&P finished the year down 38.5%, the worst performance in over 70 years. It was a year in which six years of gains were erased.

However, for what it’s worth, Friday marked the first trading day of 2009 and the bulls were raring to display new hope for the year to come. They certainly succeeded as the market shot higher with the Dow tacking on 250 points by the end of the session.

The Santa Claus rally has come to fruition this year with the S&P gaining 8% since the seasonal period began back on the 23rd of December. The seasonal time frame ends this Monday so barring a dreadful market during the next trading session, the market should once again thank Santa for bearing plenty of gifts for the holiday season. The one concern is that volume was extremely low, which is typically viewed as a lack of conviction among market participants. That might be so, but after the horrendous year that the market experienced in 2008 I am not certain that anyone is complaining about a sharp rally, regardless of its nature.
The week was once again filled with weak economic news and once again we witnessed the market virtually ignore the bad news. This has been the pattern since the market touched multiyear lows on November 20th.

Here is a sampling of the news:

• S&P Home Price Index declined 18%, the largest year-over-year decline on record
• The ISM Index, a survey of national manufacturing conditions, hit its lowest point since 1980
• ISM also reported that new orders fell to a low not seen since 1948
• Weekly jobless claims fell another 94,000

"Over the last month you've started to see a change in sentiment and this certainly advancesthat," said Carl Beck, partner at Harris Financial Group in Richmond, Va.

"We like to see the markets shrug off the bad news. That typically is a sign that we're forming a bottom," said Eric Thorne, an investment adviser at Bryn Mawr Trust.

On a technical basis the market has pushed into a short-term overbought extreme. This typically means that at minimum a short-term reprieve should occur over the next 1-3 trading sessions. I do think that after the sharp, low-volume rally from last week we should not be surprised to see a pullback next week. The major indexes are all hitting overhead resistance coupled with the aforementioned overbought conditions. Again, this is often a formula for a short-term pullback so be prepared.

"The first five days are usually very telling," Leone said. "I'm not sure we'll be up or down." He said an advance in stocks Friday wasn't a surprise as some investors start the year by wading into the market. He said selling is more likely to occur next week.

Overbought/Sold Condition Report

Overbought/Oversold as of January 3, 2009

• S&P 500 (SPY) – 80.7 (very overbought)

• Dow Jones (DIA) – 81.4 (very overbought)

• Russell 2000 (IWM) – 74.9 (overbought)

• NASDAQ 100 (QQQQ) – 80.4 (very overbought)

• Oil Services (OIH) – 80.7 (very overbought)

Testimonial of the week

I have been trading the equity markets with many different strategies for over 40 years. Terry Allen's strategies have been the most consistent money makers for me. I used them during the 2008 melt-down, to earn over 50% annualized return, while all my neighbors were crying about their losses. ~ John Collins